Is LIBOR Fixable?

Some regulators think LIBOR, the benchmark for short term interest rates that is fixed by a group of bankers in London, can be fixed. Others feel it is irreparably damaged and was a myth from the start.

Britain’s top financial watchdog delivered a 10-point plan to fix Libor but stopped short of scrapping the benchmark interest rate in a much-awaited reform of a system plagued by scandal.

“The system is broken and needs a complete overhaul,” said Martin Wheatley, head of the Financial Services Authority (FSA).

Wheatley acknowledged problems with London interbank offered rates, but said Libor is so deeply entrenched in the financial system that it cannot be easily replaced. [..]

CHARGES OF MANIPULATION

Multiple banks have been accused of trying to manipulate Libor, a series of rates set daily in London. Barclays in June agreed to pay $453 million to U.S. and British authorities to settle allegations that it tried to move Libor to help its trading positions.

Wheatley’s programme for reform includes auditing banks that contribute data used to calculate the rates, to ensure they are not submitting false rates to benefit trading positions. [..]

SHRINKING THE NUMBER OF RATES

Rates that are infrequently referenced in trades, such as Australian and Canadian dollar rates, will be phased out, Wheatley said. Maturities that are infrequently used, such as four, five, seven, eight, 10 and 11 months, will also be ended.

The reductions will shrink the current number of Libor rates set daily to 20 from 150. Rates that are rarely traded are easier to manipulate.

There were two implicit assumptions in Libor. One was that banks were virtually risk-free, or at least that their risk was small and would not vary much over time. The other was that there was a way to actually calculate what the rate was. Both assumptions turned out to be wrong.

Libor rates are calculated each day by the British Bankers’ Association, a trade group that makes good money from licensing the use of Libor rates. [..]

The scandal made clear that those reports were faked before and during the financial crisis by at least some of the banks. But what is not as widely appreciated is that there is substantial evidence that the deception goes on. Banks continue to report figures that strain credulity, both in their level and in their lack of volatility from day to day or week to week. [..]

The bank regulators believed the fiction. Banks that owned AAA-rated floating rate assets needed to keep virtually no reserves on hand to back them.

We all know what happened. It turned out that risks were far greater than had been realized. Banks failed or were bailed out. Investors in AAA securities suffered major losses.

Libor was manipulated by bankers long before the financial crisis, and it is still based on calculations that have little basis in reality. Mr. Wheatley assures us that more regulation can deal with conflicts of interest. There will, he promises, be a “clear code of conduct” and “clear rules,” enforced by a regulator with “extensive powers.”